What are Subprime Mortgages? | Money
There aren’t many loan options for borrowers with low credit scores or other economic roadblocks when financing a home purchase. However, if a potential homebuyer can afford the monthly payments and is conscientious about meeting the financial responsibility of paying for a mortgage, subprime loans can be a good choice.
Read on to learn about subprime lending, who can benefit from it and what you need to beware of.
What is a subprime mortgage?
A subprime mortgage is a loan offered to borrowers with poor credit scores (typically 619 or less). Subprime loans can also be called non-prime loans or non-qualified mortgages. The most common applicants are people with a previous foreclosure, bankruptcy or other negative information on their credit report.
Due to the higher risk, subprime loans tend to charge a higher interest rate than conventional mortgages and other traditional forms of financing like FHA and VA loans, which the federal government guarantees. Lenders also often require larger down payments to secure the funding, anywhere from 10% to 30% of the home’s sales price.
Types of subprime mortgages
Just as there are various loan options for borrowers with high credit scores, there’s also a spectrum of subprime mortgages for borrowers with less-than-stellar credit. Here are the four you’re most likely to encounter:
Fixed-rate mortgages
As the name implies, fixed-rate subprime loans have an interest rate that won’t change throughout the life of the loan, so your monthly payment will always be the same. These loans are typically longer than traditional mortgages: Some subprime loans can have 40 or even 50-year loan terms, while prime mortgages (those for borrowers with good credit scores and better financial history) typically have 15 or 30-year terms.
Adjustable-rate mortgages
Adjustable-rate subprime loans have a fixed interest rate for a predetermined number of years. After the fixed-rate period ends, the interest rate will fluctuate at set intervals based on market conditions. This variability means the rate can increase or decrease every time a new adjustment period begins.
Most subprime loans will have an adjustable interest rate — however, lenders usually cap rates to prevent excessive increases. Before applying for a non-prime loan, verify the lender’s highest rate.
Interest-only mortgages
With an interest-only mortgage, your monthly payment only covers the interest accrued on the loan balance for that month. Typically, you’ll only pay interest for the first seven or ten years of the loan, depending on your lender’s terms, after which you’ll start paying both principal and interest each month. While this type of loan has lower initial payments, these can significantly jump once you start paying principal and interest.
Dignity mortgages
Dignity loans combine a subprime loan and a conventional mortgage. The borrower makes a 10% down payment on the property and agrees to pay a high interest rate for the first few years of the loan (usually the first five years). If the borrower makes all the monthly payments on time, the lender will lower the interest rate to a “prime” rate offered to applicants with better credit scores.
Advantages and disadvantages of a subprime mortgage loan
There are pros and cons to financing any large purchase. Before moving ahead with a subprime loan, know the pros and cons so you can make an informed decision.
The advantages of subprime mortgages
Non-prime loans aren’t for everyone, but they can provide benefits under certain conditions. Those include:
Accessible homeownership
The most significant advantage of a subprime loan is that it provides borrowers with bad credit histories or below-average credit scores with an opportunity to obtain financing and purchase a home.
Improved credit standing
The subprime borrower, who by definition has a poor credit history, can improve their credit by making monthly mortgage payments on time. In some cases, these borrowers can increase their credit score drastically enough to refinance into a lower interest rate down the road.
Wealth-building
Subprime homeowners who meet their repayment obligations can also build up their home equity. Over a sustained period, they can use that equity to increase their personal wealth or fund investments that better their overall financial health.
The disadvantages of subprime mortgages
Subprime mortgages involve a higher level of risk for both the lender and the borrower. Here are the main downsides you should be aware of.
Higher interest rates
Because the mortgage lender is taking on considerably more risk with a subprime borrower, the interest rate offered is higher than on a prime loan (as much as 8% or 10% higher). As a consequence, your monthly payment will also be much higher.
Higher upfront costs
Most lenders require a high down payment on a non-prime loan. Sometimes, borrowers are required to put 25%-35% down to qualify. Closing costs and other lender fees will also be higher than with a prime loan, so you’ll likely need to put up a sizable amount of cash upfront to close the deal.
More expensive over time
You’ll be paying a much higher rate for an extended period — as long as 40 years in some cases. Your total interest paid on the loan, plus the higher upfront costs, make subprime mortgages very expensive.
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How to get a subprime mortgage loan
Your first step in finding a non-prime mortgage is to find a lender that caters to borrowers with less-than-perfect credit.
You can start your search with our list of the best mortgage lenders and compare credit score requirements and loan options, but don’t be afraid to expand your search. Look for companies identified as either subprime, non-prime or non-QM lenders.
Once you’ve identified several subprime lenders, compare their offerings. Look at the minimum credit score they’ll work with, interest rates offered, down payment requirements, closing costs and other fees and the terms associated with the loan. Use a mortgage calculator to estimate how much you’ll pay each month. Ask questions and make sure you’re comfortable with the lender you pick.
The loan application process is similar to a conventional or prime loan, including providing proof of income and the ability to repay the loan. Ensure you have all your financial documents readily available to speed up the process.
Alternatives to subprime lending
Buying a home with bad credit is difficult but not impossible. Depending on your personal financial situation, credit score and repayment history, you may have borrowing options outside of non-prime lenders.
FHA loans: FHA loans are guaranteed by the Federal Housing Administration. They offer lower interest rates than conventional loans and have lower down payment and credit score requirements. A homebuyer with a 580 credit score and a 3.5% down payment typically qualifies for an FHA loan. The minimum credit score drops to 500 if the borrower puts 10% down.
VA loans: Veterans, active duty military, and some military spouses and beneficiaries qualify for a loan guaranteed by the Department of Veteran Affairs. VA loans require no down payment and offer competitive interest rates. The VA doesn’t have a minimum credit score requirement, but most lenders will ask for a score of 620 or higher.
USDA loans: Buyers planning on purchasing a home in a rural area may qualify for a loan guaranteed by the U.S. Department of Agriculture. There are no down payment requirements, and the USDA has no minimum credit score requirements, though lenders may ask for a score of 640 or higher for expedited processing.
Do subprime mortgages still exist?
Subprime mortgages still very much exist, although they’re better known today as non-prime or non-qualified mortgages (non-QM loans).
This type of home loan was popular during the run-up to the housing bubble of 2007 and is often blamed for the financial crisis in the housing market that followed. Between 2004 and 2006, lenders offered subprime mortgages to borrowers who didn’t qualify for prime-rate mortgages.
When the housing bubble burst and home prices dropped, many subprime borrowers could no longer afford their loans and defaulted. Millions of American homeowners went into foreclosure and lost their homes. Subprime loans disappeared from the mortgage market in the aftermath but have since made a comeback, with regulations in place to prevent a repeat of the 2007-2010 housing crisis.
Are subprime mortgages illegal?
Subprime mortgages are not illegal and can benefit borrowers with fair to poor credit who are financially responsible or those who have been in bankruptcy or had a previous foreclosure.
As a result of the housing market meltdown, and in light of the role subprime mortgages played in the debacle, the Consumer Financial Protection Bureau (CFPB), a government agency created to monitor financial institutions, established restrictions on this type of loan, including caps on how high the interest rate charged can go, strict underwriting guidelines and required homebuyer counseling by a provider approved by the U.S. Department of Housing and Urban Development (HUD).
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Summary of Money’s What are subprime mortgages?
Subprime mortgages are loans designed for potential homebuyers who otherwise would not qualify for a loan due to their poor credit score, previous bankruptcy, foreclosure or other adverse financial history. But there are tradeoffs: while subprime loans offer an opportunity for homeownership, they require higher down payments and charge higher interest rates than prime loans. Anyone considering a non-prime loan should carefully consider all the pros and cons before applying.